Banking & Central Banking: Roles, Functions & Operations

TAKEAWAYS:

• Central banks (like NRB) regulate money supply, issue currency, and act as lenders of last resort to stabilize economies.
• Commercial banks create credit through fractional reserve banking, but must maintain liquidity ratios (e.g., 8% in Nepal).
• Monetary policy tools (open market operations, repo rate, CRR) directly impact inflation and economic growth.
• Banking risks (credit, liquidity, operational) require prudential norms like Basel III compliance.
• Digital banking (eSewa, Khalti) relies on central bank oversight to ensure payment system security.
• Central bank vs. commercial banks: One controls monetary policy; the other provides financial intermediation.

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Core Concepts: Central Banking in Nepal

1. Definition and Role of Central Bank

The central bank is the apex financial authority in a country, responsible for:

• Monetary policy (controlling money supply and interest rates).
• Currency issuance (e.g., NRB prints and distributes Nepali rupees).
• Banker to the government (manages public debt and fiscal operations).
• Lender of last resort (provides emergency liquidity to commercial banks).

In Nepal, the Nepal Rastra Bank (NRB) performs these roles under the Banking Act 2002. Its key functions include:

• Regulating commercial banks (e.g., setting reserve requirements).
• Supervising financial stability (e.g., stress-testing banks during crises).
• Managing foreign exchange (e.g., intervening in the NPR/USD rate).

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2. How Central Banks Control Money Supply

Central banks use three primary tools to influence the economy:

WORKED EXAMPLE: Open Market Operation (OMO) Scenario: NRB injects Rs 20M into the banking system by buying g-secs. The required reserve ratio (RRR) is 8%. Question: What is the total demand deposit created?

Solution:

1. Initial Injection: Rs 20M → banks’ reserves increase by Rs 20M.
2. Money Multiplier (m): $m=\frac{1}{\text{RRR}}=\frac{1}{0.08}=12.5$.
3. Total Deposit Creation: $\text{Initial Injection}\times m=20M\times 12.5=\text{Rs 250M}$.

Mermaid Diagram: Money Multiplier Process

REAL WORLD:

• eSewa & Khalti rely on NRB’s oversight to ensure digital transactions are secure and liquid. If NRB tightens liquidity (e.g., raises CRR), these apps may face higher processing fees.
• Ncell’s loan disbursements depend on commercial banks’ lending capacity, which is influenced by NRB’s repo rate. A lower repo rate → cheaper loans for Ncell’s customers.

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3. Commercial Banking Operations

Commercial banks perform three key functions:

1. Accepting deposits (current, savings, fixed).
2. Granting loans (personal, business, mortgage).
3. Facilitating payments (cheques, NEFT, digital wallets).

Ledger Accounting: T-Account Example Scenario: Kathmandu Retail Shop borrows Rs 500,000 from Global IME Bank for inventory.

  Cash Account (Asset)
  Dr (Debit) | Cr (Credit)
  -----------|-----------
  500,000    |           | *Loan received → Cash increases*

  Loan Account (Liability)
  Dr (Debit) | Cr (Credit)
  -----------|-----------
           | 500,000    | *Bank’s liability to the shop*

Banking Cycle Visualization

REAL WORLD:

• Daraz’s supplier financing works like a loan: Daraz (or its bank partner) provides short-term credit to sellers, which is monitored by NRB’s prudential norms.
• NTC’s infrastructure loans from commercial banks are subject to NRB’s loan-to-value (LTV) ratios (e.g., max 80% of project cost).

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4. Banking Risks and Regulations

Commercial banks face three major risks:

WORKED EXAMPLE: Loan Classification Scenario: Pathao’s driver takes a Rs 200,000 loan but misses 3 payments. The bank classifies it as:

• Substandard (past due 90+ days).
• Doubtful (if recovery is uncertain).
• Loss (if written off).

NRB’s Prudential Norms:

• Capital Adequacy Ratio (CAR): Banks must hold 8% Tier 1 capital (e.g., Rs 800M capital for Rs 10B loans).
• Non-Performing Loan (NPL) Limit: Max 5% of total loans can be NPL.

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5. Central Bank vs. Commercial Banks: Key Differences

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6. Monetary Policy Tools in Nepal

NRB uses four main tools to manage inflation and growth:

1. Repo Rate: Current rate = 6.5% (as of 2024).

   • Effect: Lower repo → cheaper loans → higher spending.
   • Example: NRB cuts repo rate → Ncell’s mobile loan interest drops from 12% to 10%.

2. Reverse Repo Rate: Current rate = 5.5%.

   • Effect: Banks park excess cash with NRB → reduces liquidity.

3. Cash Reserve Ratio (CRR): Current = 3%.

   • Effect: Higher CRR → banks lend less → money supply shrinks.

4. Statutory Liquidity Ratio (SLR): Current = 8%.

   • Effect: Banks must hold liquid assets (g-secs, gold) → limits risky lending.

REAL WORLD:

• Inflation in 2023 (10.5%) led NRB to raise the repo rate to 7% → higher EMIs for home loans.
• COVID-19 (2020): NRB cut repo rate to 5% → boosted SME loans via Laghu Udyog Aghadi.

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Exam Tip

1. Memorize NRB’s current rates (repo, reverse repo, CRR, SLR) for numerical questions.
2. Money multiplier formula: $\text{Total Deposit}=\frac{\text{Initial Injection}}{1-\text{RRR}}$.
3. Risk management: Link NPLs to Basel III norms (e.g., "NMB’s NPL ratio is 4%, below NRB’s 5% limit").
4. Policy tools: Know which tool is used for inflation control (higher CRR/repo) vs. economic stimulus (lower repo).
5. Real-world tie-ins: Always relate answers to Nepali examples (e.g., "If NRB raises CRR, eSewa’s liquidity may reduce").

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Final Note: Banking and central banking are interconnected. NRB’s policies directly impact commercial banks’ lending, which affects businesses like Daraz, Ncell, and NTC. Mastering this unit requires understanding both theory (how tools work) and application (real-world impact). Practice numericals on money creation, loan classification, and monetary policy effects to score full marks.